mcgraw-hill/irwin ©2008 the mcgraw-hill companies, all rights reserved chapter6chapter6...

McGraw-Hill/Irwin©2008 The McGraw-Hill Companies, All Rights Reserved

CHAPTER

6

CHAPTER

6Residential Financial

Analysis

6-2

Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved

Incremental Borrowing CostIncremental Borrowing Cost

• Compare financing alternatives What is the real cost of borrowing more

money at a higher interest rate? Alternatively, what is the required return to

justify a lower down payment? Basic principle when comparing choices:

What are the cash flow differences?

6-3



• Example 6-1: Home Value = $150,000 Two Financing Alternatives

• #1: 90% Loan to Value, 8.5% Interest Rate, 30 Years

• #2: 80% Loan to Value, 8% Interest Rate, 30 Years

It appears there is only a .5% interest rate difference, but…

6-4



Alternative #1 Alternative #2

LTV 90% 80%

i 8.5% 8%

Term 30 Years 30 Years

Down payment $15,000 $30,000

Loan $135,000 $120,000

Payment $1,038.03 $880.52

6-5



• Cash Flow Differences Borrow $15,000 more Pay $157.51 per month more

= $15,000

= $157.51

= 360

= $0

= 12.28%

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6-6



• 12.28% represents the real cost of borrowing the extra $15,000.

• Can you earn an equivalent risk adjusted return on the $15,000 that is not invested in the home?

• Alternatively, can you borrow the additional $15,000 elsewhere at a lower cost?

6-7



• In example 6-1, what if the borrower expects to relocate after 8 years?

• We need the future expected loan balances: Alt #1: $123,810.30 Alt #2: $109,221.24 Difference: $14,589.06

• This becomes a future value in our analysis.

6-8



• Cash Flow Differences

= $15,000

= $157.51

= 96

= $14,589.06

= 12.40%

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6-9



• Use of discount points Analysis would change

• Depending on the points, the cash flow difference at time zero would change.

• In example 6-1, the $15,000 difference would change.

• Different maturities In Example 6-1, let’s change the term of the

alternative #2 to 25 years.

6-10



Alternative #1 Alternative #2

LTV 90% 80%

i 8.5% 8%


Down payment $15,000 $30,000

Loan $135,000 $120,000

Payment $1,038.03 $926.18

6-11



• Cash Flow Differences At time 0: $15,000 For the first 300 months: $111.85 For the final 60 months: $1038.03

6-12



• Using the Cash Flow Register,

= $15,000

= $111.85

= 300

= $1038.03

= 60

= .8926 x 12 = 10.71%

C0

CPT

C1

F1

C2

F2

IRR

6-13


Loan RefinancingLoan Refinancing

• Borrower consideration Lower interest rates in the market than on the current

loan The borrower can secure lower monthly payments There is a cost to refinance

• Application of basic capital budgeting investment decision: What is our return on an investment in a new loan?

6-14



• Example 6-2: A borrower has secured a 30 year, $120,000

loan at 7%. Fifteen years later, the borrower has the opportunity to refinance with a fifteen year mortgage at 6%. However, the up front fees, which will be paid in cash, are $2,500. What is the return on investment if the borrower expects to remain in the home for the next fifteen years?

6-15



• Initial Loan: $120,000 30 Years 7% Interest Payment = $789.36

• 15 Years Later Loan Balance = $88,822.64 New Payment at 6% = $749.54

6-16



• Cost = $2,500

• Benefit = $48.82 per month for 15 years

= ($2500)

= $0

= $48.82

= 180

= 22.62%

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6-17



• In Example 6-2, what is the return on investment if the borrower expects to relocate after seven years and not remain in the home for the full fifteen years? Now we need the expected future loan

balances for the original loan and the possible new loan.

6-18



• Original Loan Balance = $58,557.76• Refinanced Loan Balance = $57,036.41• Difference = $1521.35

= ($2500)

= $1521.35

= $48.82

= 84

= 20.93%n

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6-19



• In Example 6-2, refinancing appears to be a good investment.

• Other methods Effective cost of refinancing Borrowing the refinancing cost

• Biweekly payments

6-20


Market Value of a LoanMarket Value of a Loan

• How much would an investor pay for the loan? The investor is buying the cash flow stream of

the loan. Discount loan cash flow at the market rate of

interest that the investor can earn on equivalent risk investments.

6-21



• Example 6-3: $100,000 Loan 30 Years 6% interest Payment = $599.55 One year later, book value = $98,771.99 But market interest rates are 7%.

6-22



• The investor will not pay book value.

• To compute the market value:

= $599.55

= 348

= $0

= 7

= $89,201.49

Compare this to book value.

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6-23


Effective Cost of Multiple LoansEffective Cost of Multiple Loans

• Basic Technique Compute the payments for the loans Combine into a cash flow stream Compute the effective cost of the amount

borrowed, given the cash flow stream. Compare the cost to alternative financing

options.

6-24



• Example 6-4: You need a $500,000 financing package. $100,000 at 7%, 30 Years

• Payment = $665.30

$200,000 at 7.5%, 20 Years• Payment = $1611.19

$200,000 at 8% 10 Years• Payment = $2426.55

6-25



• Using the Cash Flow Register,= $500,000= $4703.04= 120= $2276.49= 120= $665.30= 120

= .6239 x 12 = 7.49%

CF0

CPT IRR

C1

F1

F2

C3

F3

C2

6-26


Below Market FinancingBelow Market Financing

• A seller with a below market rate assumable loan may increase the home price. All else equal, a buyer is paying a higher price

for lower payments. Similar to other problems, we compute i and

compare it to other equivalent risk investments.

6-27



• Example 6-6: Identical Homes A & BA B

Price $120,000 $115,000

Loan Balance $80,000

(assumable)

$80,000

(new loan)

Down payment $40,000 $35,000

I 7% 8%


Payment $620.24 $669.15

6-28



• In Example 6-6, the buyer can secure below market financing by paying $5000 more for an identical home.

• The below market financing results in a monthly payment of $48.91 less than if regular financing was used.

6-29



= $5000

= $0

= $48.91

= 240

= 10.20%

• The buyer earns 10.20% on the $5000 investment by reducing the monthly payment by $48.91.

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6-30


Additional Financing ConceptsAdditional Financing Concepts

• Cash Equivalency

• Wraparound Loans

• Buydown Loans

• Home Equity Loans

• Home Equity Lines of Credit

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